Skype & Microsoft: Three Months On.

It’s been three months, we’re all still nursing headaches trying to work out what the hell happened after that third mojito, and Microsoft has still bought Skype.

The dust has settled, as they say.

While they work their way through the long, hard slog of divisional re-architecture, let’s see if we can take a fresh look and gain a better understanding of the acquisition from a strategic point of view.

In the weeks following, a number of potential theories cropped up as to the driver for the acquisition. The only only indicator that matters (stock price) barely registered a blip - of course, $8B in a $300B company is a mere 2.6%. Comparing MSFT to some standard indicators, we can see that MSFT has stuck true to it’s recent tradition of tracking the market.

MSFT, Dow Jones, NASDAQ, and S&P500. Notable events are: (D) - ex dividend, (K) - Nokia agreement (February) and Skype purchase (May), respectively. Chart courtesy Yahoo.

While you and I may not agree with the market on questions of technology assessment, they are an extremely good indicator of executive communication. If the men at the top are doing their job, then the market should clearly understand how value is going to be added. Worse would be a market that understands but disagrees, but I’m sure that’s not the case here.

Blast from the Past: Microsoft & Long-Term Plays.

It’s hard to argue that Microsoft lacks tenacity. One key element of the company’s success has been it’s ability to spend a king’s ransom in engineering time, eventually surfacing with a marketable product.

Their approach has been one of brute force - throw extraordinary resources at a problem, and it is sure to find itself solved.

If you can’t be smart, at least be thorough.

Microsoft R&D expenditure, as compared to industry. Chart courtesy Silicon Alley Insider.

For years this approach found tremendous success, and it is only in recent years that they have been bested by the one thing money can’t buy - taste. And now that the market is beginning to see that technology R&D investment can be managed well, metrics such as “Return on Research Capital” (RORC) are starting to see use.

That’s not to say that Microsoft lacks brainpower: they are chock full of some of the brightest minds on the planet, however in their transition to a "Big Company" they have created a perverse incentive scheme regarding employee ranking and performance. The simple act of joining a team creates moral hazard.

That said, I do believe that Microsoft does well at long term plays - Media Center, Windows Mobile, Small Business Server, Bing, C# / Mono / Silverlight, the whole Windows NT development project, Windows Phone 7 - these were very long term plays, generally derided at the time, but all were, are, or are on track to be, successes by some measure.

(Yes, I'm counting Bing as a success. It has enjoyed continual investment, and as a structural component for their online and mobile products, it’s looking good.)

Of course, these pale in comparison to the graveyard of failed acquisitions - Acquantive and Danger being the most recent high profile examples.

I'm sure they have something in mind for Skype, but their ability to execute seems to have “dropped off”, to put it mildly. So, here's the question in a different way:

Assuming execution is perfect, the best case scenario is that Skype adds at least $8.5Bn of value to Microsoft.

How?

You have 3 hours, no graphic calculators allowed. Mark your name on the front of the paper and raise your hand if you need an extra booklet.

[Mergers & Acquisitions]

There’s a general consensus in the business world that M&As are quite risky, in terms of preserving and growing shareholder value. When a company has been tremendously successful in its core business, they are expected by their shareholders to only spend their profits in a way that will provide growth at a rate similar to their core business. This may sound like mental gymnastics, but the short story is that being good at what you do sets high expectations - and that can be hard to live up to.

From the buyer’s point of view, the valuation of the purchase represents the “Net Present Value” of all future gains resulting from the acquisition - in today’s dollars, how much extra money do I stand to make, in the future, from buying this company? The bargaining process, therefore, is about how much of this potential gain I am willing to give away. Give too much away, and you find yourself subject to the “Winner’s Curse”. Christofferson, McNish, and Sias have a very readable paper on this subject, explaining the buyer’s tendency to overvalue synergy benefits, delivering greater shareholder value to the seller rather than the buyer.

In a competitive bidding process things are a little different, as different bidders will also be weighing up the cost to their business if a competitor makes a successful acquisition. There's a theory going that $8Bn was the price MS was willing to pay to stop Skype going to Google. I'm not sure they're that daft with other people's money, but I'm not a CEO.

The other part of the process to bear in mind is the strategy expressed in the bidding process itself. For example, we don’t actually know how “serious” each bid was - Theories abound that Google’s was a feint, Facebook just wanted API access (and to prevent Google from getting it), and Apple..well, Apple is laughing as Microsoft slowly implodes.

All this, and from our point of view all we see is Microsoft throwing cash around like Enron at Christmas.

Here's the purchase from the point of view of a co-founder of Andreessen Horowitz (the VC fund that will walk away with a fair chunk of $4.5Bn), and here's a neat little summary of who makes what (the meat is at the end).

So, what possible reasons for the actual buyout are we left with?

Here’s a thoroughly incomplete list;

1. Technology
2. Relationships
3. Talent
4. Brand
5. User Base
6. Strategic Enablement & Advantage

Technology, Bye.

I think we can all agree that this isn't a technology buy. There's nothing Skype has that couldn't be built (or purchased elsewhere) for less that a few billion. Regardless of whether they have an existing product that meets the same spec (such as "Lync", formerly "Office Communications Server"), the financially informative question remains whether the same cash could create the same product for less. I’m sure of it.

Technology-wise they could choose to reposition Skype’s network as an online service. Microsoft has actually proven themselves quite capable at leveraging an existing community of users - certainly more so than Skype, the most notable being the Hotmail transition. They take their time, but it does get done.

While interesting, this model doesn’t fit. Skype has no history as a pure online play (they’re certainly not a "web service"), although they do have good technical know-how in network and latency management. There have been some recent moves to form a strategic alignment with Facebook, however the java applet approach doesn’t stray too far from their traditional client/server mold. All said and done, this is simply Facebook using Skype’s technology as a leveling tool to compete with Google.

Imagine that you were launching a social or online platform today and you insisted that every user download a client application. You’d be laughed out of the park. No, I don’t think we’re going to find our answer here.

I think we can also dismiss carrier, OEM and commercial relationships - Microsoft has been making phones longer than Skype has been out of diapers. And while Skype does have a consumer friendly brand, it’s userbase is dwarfed many times over by Microsoft's own services.

That leaves strategy.

Windows, PCs, & OEMs: What’s the Big Deal?

While it’s fun to focus on the trendy products, it’s important to note that the PC business is still growing. Plenty of businesses are making plenty of money by simply selling desktop computers - and the simple PC has long been a staple of any business desktop (I have four).

While there has been some very slight competition in this area, I doubt there is cause for much concern. Microsoft’s defence of this ground has been ferociously effective - the highway of the corporate desktop is littered with the corpses of many a “free” or “easy to manage” Windows alternative. While I’m sure ChromeOS may eventually see some success (and I will certainly recommend it to my parents), it doesn’t quite seem to be targeted correctly.

“Commoditisation” is often trotted out as a reason that Microsoft should be concerned about this market, however I believe this is a little misguided. While I agree with the sentiment that the OS has been commoditised, this is only from the perspective of the user.

In practise, it isn't the user that chooses the OS, it's the OEM. it does still cost a PC maker money to place an OS on their device - and Microsoft have an attractive proposition for PC makers - decent unit pricing, full driver development and QA support, ecosystem development, and downstream user support in the form of regular patches and updates. Think about how much of your computing experience comes from Microsoft rather than Dell, and that's a pretty good expression of how much work Dell doesn't need to do. "One less thing to worry about" is a very attractive proposition to a business built entirely on margin.

On the flip side, witness Google's own efforts to commoditise the OS from the OEM’s point of view. They're essentially cross-subsidising OS development and support from their advertising revenue, to provide cheaper access to their web services.

Unfortunately Google’s stated target of the "managed" (ie corporate) desktop doesn't seem quite right - these are precisely the people that do not have a problem with desktop maintenance, with on-site support teams that have an intrinsic distrust of external service providers. These are folks that have grown up with Microsoft's mantra of "You're an adult. Here are the tools, go manage your systems yourself."

They may have more success in the consumer space if they can match Microsoft's value proposition, as web browsers have almost completely disintermediated the operating system for whole swathes of the population. To most consumers “computer” means “a device for using Facebook”.

So, there's a lot of life in the old girl yet, as they say. The OS (as a value-bearing product) isn't going anywhere any time soon, we just need to be aware who is creating the value, and who's capturing it.

The increasing proportional cost of the Windows license is often also brought up, though I would stress that software is a zero marginal cost product - Microsoft can (and does) use pricing as a competitive tool, lowering prices to whatever threshold makes it worthwhile keeping the OS Somebody Else's Problem. Windows licenses (notably Starter) actually get cheaper on low-cost systems, in what has been a remarkably successful strategy to knock the legs out from under the Linux netbook market.

It's a race to the bottom for OEMs, not Microsoft. And a race to the bottom isn't a problem if you own the whole bottom.

Note that the iPad is eating PC OEMs' lunch in the low-cost consumer space because it is a good, well-designed product at a competitive price, in a market that doesn't care about Microsoft Office. Facebook and Hotmail, that's all you need (I would wager that most iPad owners hardly even use the "Mail" app). It's not pricing that's the problem, it's the lack of a decent product in a market that has no legacy support requirements.

That all said, We don’t actually care about existing products. The key point that we’re looking for is growth.

Share price growth is founded on potential future revenue growth - and there's no news in "Microsoft is going to sell a bunch of Windows and Office licenses". No new products, no new markets, no bump to the share price.

There have been a few stilted attempts to create new value around existing products (see Software Assurance), however I’m not willing to file a change in licensing under “new growth” - regardless of whether it's per seat, per unit, per subscription, or some other creative method that amounts to flogging the same product with a slightly different business model.

To bump the share price we need to see Microsoft either (a) go after new markets, or (b) create new products. I see neither, and we aren’t seeing any activity that justifies $8.5Bn.

Strategic Misfits.

Much as I hate to admit it, this does seem like a classic "we're in the shit, let's buy someone!" move. I'm reminded of HP's acquisition of Compaq, Cisco of Flip, not to mention what Microsoft themselves did to the poor Danger group (bought a great startup with a great product, sat on it for three years, rebuilt the product from scratch, released an awful product (the "Kin"), then killed the whole group a month later. Poor fellows).

In other areas they're actually being less daft;

1. Microsoft does actually make money from XBox, and has done so for a few years. It's a bit of a success story for Microsoft's previous core strengths - patience and discipline. Like it or loath it, there are no industry commentators denying Microsoft’s membership in the gaming industry. That’s not a sentence I expected to write a decade ago when I was pumping out an iBook review.
2. Windows 7 has been widely hailed as a success, selling 350 million licenses in it's first 18 months. The huge swathes of user asking for XP downgrades are largely gone. They shipped a decent product, and now they're making a ton of cash. Office also.
3. Windows Phone 7 (as a long term play) is actually doing quite well, and arranging a coup at Nokia (their "new" CEO, Stephen Elop, was head of Microsoft's Business Division until 2010) to make sure an Actual Real Life Phone Company builds decent Windows Phone devices was positively inspired. That's the Microsoft we all know and love. (Side note: I used a Windows Phone yesterday for the first time. Surprisingly awesome. I can see where the Danger fellows went.)

Everyone (Google, Facebook, Microsoft, Apple) is trying to position themselves well in mobile, communications, and social - each playing to their own strengths. Skype sort of matches the template for that, but we’re still not seeing anything that Microsoft doesn’t already have or couldn't build. We'll certainly see Skype "Built! Right! In!" to Windows Phone 7 soon enough, but how, exactly, does that create new markets or products? Seems arse about, building a platform around a feature, instead of the other way around.

Walking Right In: The Future of the Upwardly Mobile.

Skype is all about communication, and communication is inextricably tied up with mobile.

In mobile, Microsoft is looking to use the same strategy that found success in the PC market: be the "default" option for devices requiring a third party licensed operating system.

Looking at current market share numbers, Microsoft sees everyone that isn't Apple or RIM (and I’m not so sure about RIM) as a potential licensee, and the worse each manufacturer does individually, the more likely they are to accept the "help" of Microsoft. Microsoft can then let them diversify among themselves, from low-end feature phones to high end smart phones.

It's a nice plan, except;

1. Apple is eating everyone's lunch at the high end. Regarding actual share of profits:
   
   Profit share of top eight mobile phone vendors. Chart courtesy asymco.com
   
2. The low-end is soon to be taken over by cheap-and-cheerful Chinese hardware / software combos, for whom any unit license fee is unreasonable and there's a constant game of "Hooray! Race to the bottom!"
   
   There's a huge portion of the market for whom free isn't cheap enough - the “basic feature phone with a prepaid SIM” customer, like my dad. There's an enormous low end to the market that Microsoft and Google both want, but neither will get - it will be clearly left to the Chinese and Koreans.

(Interesting Side Note on “Value”:

There’s a principle in business that there are two key steps to making money:

1. Generate value. Create something that, in some way, adds value to the life of someone in the community. You could be giving someone a nice back massage, you could be providing a high performance database, it could be some fancy machine that records inbound sales leads when all the phones are busy, or it could be a standard platform format so that large groups of people now have an easier time working together. In each case, value is being created for someone (note that “value” doesn’t necessarily mean “money”).
   
2. Capture value. This is the hard part. A successful business will profit when people are benefiting from it’s products. Bloomberg provided a single, integrated information terminal when the rest of the world was leafing through telex - and they have profited handsomely. On the other hand, IBM gave the world a standard hardware platform on which to develop PC hardware and software, but it’s PC division slowly imploded while others in the stack (notably Microsoft) took advantage.

With this in mind, it’s useful to observe that the graph above is for businesses that are both vertically integrated (Apple, RIM, Nokia) and hence retaining most of their generated value, as well as those that used a licensed OS, generating value for some third party.

Android phones generate a lot of value for Google (directly as search advertising revenue and and indirectly in metadata acquisition and platform network effects), but we don't see that on this graph. Likewise, Windows Phone 7 phones may one day generate a lot of revenue for Microsoft, but that wouldn't be captured here.

I'd be interested in seeing some breakdown of value generation from the OS platform originators, or perhaps some kind of combined value of system integrator + software supplier. Just a thought.)

Note that system integrators (HTC, Sony Ericsson, LG, Samsung, etc) don't care what software they use - they'll switch at a moments notice to whatever is most profitable. There's a struggle going on behind the scenes as Microsoft and Google actually bid against each other for business from the system integrators, throwing money where ever it's likely to find a home.

Hence the acquisition of Nokia, to retain a gold standard.

It's likely that we'll be seeing this struggle go on for a few years now - Microsoft and Google have too much to lose not to keep playing, RIM will see a slow, steady slide into oblivion then acquisition, and Apple will remain quietly profitable and continue a very well executed two-step. 1) Start at the top, then 2) Work your way down.

I've heard it suggested that Microsoft could create disruption by buying a US telco (such as Sprint) and selling handsets that make unlimited "Skype" data calls, effectively placing voice calls over a wireless data network using Skype. This would drop the cost of provision per customer by half, but (a) I don't think they have the balls, and (b) I don't think you need to buy a telco to make that happen. Some kind of strategic partnership would be fine, but we haven't seen any hints in that direction. Perhaps it's all part of the "master plan".

(As an Australian, I find it interesting that the US wireless telco industry is actually less competitive than here in Australia. Due to the size of our total market and each carrier’s relative market share, no carrier wields significant enough market power not to act competitively in most situations. Put simply, you’ve been able to get an iPhone unlocked from day one, and around $60 per month will get you unlimited calls and SMS, with a few Gb of data.)

In Conclusive.

There’s a wonderful scene in “Searching for Bobby Fischer” where, at the movie’s climactic match, the mentor whispers “don’t move until you see it”, referring to the wisdom of understanding all parts of a strategy before diving in.

So, while I can’t see it myself, I’m loath to follow in the footsteps of lousy journalists asking for cutlery to be stuck in large software companies, and certainly not when they’re clearly fit enough to throw around $8.5Bn.

I hope it works out, but there isn’t a clear path between “here” and “there”, where “here” is a clear reliance on two major cash cows for virtually all revenue, and “there” is a diverse, profitable revenue stream with plenty of growth potential.

They have plenty of irons in the fire (Xbox, Windows Phone, business offering extensions, their nascent online collaboration services, to name a few) but I am still in fear of the execution of the Microsoft executive team.

I imagine they are, too.

References:

Christofferson, SA, McNish, RS and Sias, DL 2004, ‘Where mergers go wrong’, The McKinsey Quarterly, Number 2, pp 92-99.

Yarow J, Angelova K 2010, CHART OF THE DAY: Microsoft Spends Eight Times As Much On R&D As Apple, <http://www.businessinsider.com/chart-of-the-day-rd-for-tech-companies-2010-5>

Dediu H 2011, iPhone share of phone market in Q1: 5% volumes, 20% revenues, 55% profit, <http://www.asymco.com/2011/05/16/iphone-share-of-phone-market-in-q1/>

Operating system market shares, <http://en.wikipedia.org/wiki/Smartphone#Operating_system_market_shares>

Horowitz B 2011, Microsoft Buys Skype, <http://bhorowitz.com/2011/05/10/microsoft-buys-skype/>

Malik O 2011, Why Microsoft Is Buying Skype for $8.5 Billion, <http://gigaom.com/2011/05/09/why-microsoft-is-buying-skype-for-8-billion/>